Market Risk Management with Stochastic Volatility Models

Abstract

Risk assessment and management have become progressively more important for enterprises in the last few decades. Investors diversify and find financial distress and bankruptcy among enterprises not welcome but expected in their portfolios. Some enterprises do extremely well and keep expected profits (and realised) at a satisfactory level above risk free rates. In contrast, corporations should be run at its shareholders best interest inducing project acceptance with internal rates of return greater than the risk adjusted cost of capital. These considerations are at the heart of modern financial theories. However, often not stressed enough, for the survival of a corporation financial distress and bankruptcy costs can be disastrous for continued operations. Every corporation has an incentive to manage their risks prudently so that the probability of bankruptcy is at a minimum. Risk reduction is costly in terms of the resources required to implement an effective risk-management program. Direct cost are transactions costs buying and selling forwards, futures, options and swaps – and indirect costs in the form of managers’ time and expertise. In contrast, reducing the likelihood of financial distress benefits the firm by also reducing the likelihood it will experience the costs associated with this distress. Direct costs of distress include out-ofpocket cash expenses that must be paid to third parties. Indirect costs are contracting costs involving relationship with creditors, suppliers, and employees. For all enterprises, the benefits of hedging must outweigh the cost. Moreover, due to a substantial fixed cost element associated with these risk-management programs, small firms seem less likely to assess risk than large firms. In addition, closely held firms are more likely to assess risk because owners have a greater proportion of their wealth invested in the firm and are less diversified. Similarly, if managers are risk averse or share ownership increases, the enterprises are more likely to pursue risk management activities. Stringent actions from regulators, municipal and state ownership and scale ownership (> 10-15%), may therefore force corporations to work even harder to avoid large losses from litigations, business disruptions, employee frauds, losses of main financial institutions, etc. leading to increased probability for financial distress and bankruptcy costs.